10 Years After SOX: PCAOB Update

Thank you for inviting me to speak today. I am delighted to be here at your 105^th annual meeting.

Before I begin, I must tell you that the views I express today are my own and do not necessarily reflect the views of the Public Company Accounting Oversight Board, any other Board member, or the staff of the PCAOB.

It has been 10 years since the passage of the Sarbanes-Oxley Act and the Board's creation. I served my first tour of duty at the PCAOB as General Counsel from 2004 to early 2007, shortly following the passage of SOX. One of our early and high priorities at the Board was to establish a cooperative relationship between the Board and the state boards of accountancy because we realized that the Board shares a common mission with the state boards and that, working together, we can better protect investors and strengthen the auditing profession.

Currently, the PCAOB shares its detailed inspection reports, including the non-public portion, with thirty-two state boards of accountancy where the inspected firm or individual holds a license to practice and as long as the state board has acknowledged in writing its awareness of the Sarbanes-Oxley Act's confidentiality restrictions. The Board also sends a letter to the other state boards of accountancy with the public portion of the inspection report for the accounting firm that is licensed to practice in that state and informs that board that it can receive the non-public portion of the inspection report if it signs the PCAOB acknowledgement and agreement form.

In addition, the PCAOB and the state boards of accountancy have been able to share certain information relating to PCAOB and state board enforcement actions. We also appreciate the letters that NASBA sent to Congress earlier this year in favor of legislation that would allow the Board to make disciplinary proceedings open to the public.

Moreover, the PCAOB benefits from the comment letters that NASBA and state boards of accountancy regularly submit on its proposals and concept releases. The insightful comments assist the Board in ultimately developing a better standard or rule. Additionally, a NASBA representative has served on the PCAOB Standing Advisory Group since its inception and a NASBA representative frequently participates in the Board's standard-setting roundtables and public meetings.

Most recently, for example, Gaylen Hansen provided his thoughtful views on the question of mandatory auditor rotation at the Board's third public meeting on auditor independence, objectively and professional skepticism in Houston.

Role and Relevance of the Auditor

The role of the independent auditor has evolved over time. This is to be expected because we live in a commercial and financial environment that itself is continuously evolving. Auditors have most often been subject to intense scrutiny following economic crises like the great depression of the 1930s, major financial frauds like the Enron and WorldCom cases in the early 2000s, and the global financial crisis and recession of 2008-2009. In such cases, investors, regulators and the public ask "Where were the auditors?" implying that the auditor should have warned them beforehand that a crisis was imminent.

Whether or not that is a realistic expectation of the role of auditors, the improvement of audit quality is central to the Board's mission. Since I joined the Board in February 2011, the Board has had an opportunity to meet with many parties who have an interest in enhancing and improving audit quality, including investors, preparers of financial statements, auditors, academic experts and regulators both in this country and abroad, and to listen to their views, ideas and concerns.

One thing has become evident to me from these discussions. There is a widespread sense, following the global economic crisis of 2008 and 2009, that existing financial reporting mechanisms of which the auditor's report on the financial statement is a central pillar failed in many cases to give any advance warning to investors and others of the risks that led to the failure or near failure of many systemically important institutions, particularly financial institutions. Many such institutions both in the U.S. and abroad received clean audit reports only months before they required massive government bailouts. Many commentators have argued that a financial reporting system that could allow the risks and underlying problems that led to the crisis to go unreported must be fundamentally broken.

Since the Board's mandate is the oversight of auditors and not issuers or audit committees, we have focused on the role of the auditor and whether it needs revision. Specifically, we have concentrated on how audit quality can be improved, on how the auditor's independence, objectivity and professional skepticism can be strengthened and on how the work of auditors can be made more transparent to the investing public.

In this regard, the Board has undertaken a number of initiatives — dealing with communications between auditors and audit committees, the auditor's reporting model, auditor independence, and transparency — which, depending on their outcome, have the potential to change the auditor's relationship both with the issuer and users of financial statements in fundamental ways.

Enhancing the Auditor and Audit Committee Relationship

Most recently, in August of this year, the Board adopted Auditing Standard No. 16, Communications with Audit Committees. The new standard establishes requirements that enhance the relevance and timeliness of the communications between the auditor and the audit committee, and is intended to foster constructive dialogue between the auditor and the audit committee on significant audit and financial statement matters.

Auditing Standard No. 16 provides a definition of the term audit committee, retains or enhances existing communication requirements, and incorporates certain SEC auditor communication requirements to audit committees, such as the requirement to communicate all critical accounting policies and procedures.

The standard also incorporates new communication requirements that are generally linked to performance requirements in other PCAOB standards, including communications about the overall audit strategy, information about specialized skills required in the audit, the use of the company's internal audit function in the course of the audit, difficult or contentious matters with respect to which the auditor believes it was necessary to consult outside the audit team, the auditor's evaluation of going concern issues, and any departures from the standard auditor's report.

While the standard establishes certain requirements regarding auditor communications to the audit committee, it does not preclude the auditor from providing additional information to the audit committee. The standard sets the minimum but not maximum standard for communications. Nor does the standard preclude the auditor from responding to audit committee requests for additional information from the auditor. If audit committees want additional or more detailed information about particular topics, their members remain free to ask their auditors any questions, and request information they believe would help them understand the audit and the finances of the companies they oversee.

Some commentators have questioned the need for such a standard, contending that audit committees already routinely seek and get this information and that setting up requirements will inevitably lead to a "check the box" approach to audit committee communication. The Board disagrees. Through our inspection work, the Board has come to understand that there exists a wide range of expertise and sophistication on audit committees — there are some audit committees, particularly in the largest companies, whose members possess great technical and industry expertise. There are many other audit committees, however, whose members are less experienced or do not have the technical expertise to understand complex financial and accounting matters. For the latter group, the Board believes more robust communication between the auditor and the audit committee can be useful.

We hope that the new standard and its requirements will provide greater uniformity to the communications between auditors and audit committees of public company and will insure that all audit committees are informed about some of the most important elements of the auditor's work and findings with respect to the issuer's financial statements. We believe that this can be a significant contributor to better corporate governance of the issuer.

The standard is presently awaiting approval by the Securities and Exchange Commission. Once approved by the Commission, it will become effective for all audits of fiscal years beginning on or after December 15, 2012.

Additionally, on August 1, 2012, the Board issued a release to provide information to audit committees about its inspection program and the meaning of PCAOB inspection findings. The release discusses the meaning and significance of audit deficiencies described in the public portion of an inspection report and provides a basic description of the way that audit quality control criticisms are framed in portions of an inspection report that are, at least initially, nonpublic.

The release also highlights certain areas of inquiry that audit committees may wish to discuss with their auditors, including, for example, whether the audit overseen by the audit committee was selected by the PCAOB for inspection and whether any findings were made; potentially relevant inspection findings with respect to other audits performed by the audit firm; the audit firm's response to the PCAOB findings; and the audit firm's remedial efforts in light of any quality control deficiencies that may have been identified by the PCAOB.

The release also provides the Board's perspective on certain types of assertions made in the public portions of the audit firms' responses to the inspection reports and possibly in discussions with audit committees, including assertions that characterize the criticisms as differences of opinion in professional judgment or documentation deficiencies rather than deficiencies in the performance of audit procedures to obtain sufficient competent audit evidence.

The Board hopes that this report will encourage audit committees to inspect PCAOB inspections with their auditors and will assist audit committees to better understand the Board's inspections reports.

Auditor's Reporting Model

Another standard-setting project that the Board has undertaken is the possible revision to the auditor's reporting model. I believe that this is potentially one of the most significant projects the Board has ever undertaken.

Following extensive outreach by PCAOB staff, the Board, in 2011, issued a concept release in response to commonly and vocally expressed dissatisfaction on the part of investors and other financial statement users with the current form and content of the auditor's report. This dissatisfaction is not new but has been expressed by financial statement users for decades and has been commonly termed "an expectations gap" — that is, a gap between what users expect and what the audit report delivers. What is new, however, since the financial crisis is the volume and urgency of the criticism of the current reporting model.

The current auditor's report provides a general level of information for investors and financial statement users — that the issuer's financials statements and footnote disclosures are presented fairly in all material respects and in conformity with the applicable accounting framework. Unfortunately, this pass/fail model — while useful generally - does not provide the types of specific information that investors and other financial statement users are seeking.

Commerce grows ever more global and financial transactions grow ever more complex. Those facts, coupled with the evolution of accounting standards away from historical cost accounting toward fair value accounting means that financial statements and footnote disclosures are now comprised of numbers that are based on management's estimates of many things such as the fair value of assets and liabilities rather than amounts that can be measured precisely. The increasing use of complex financial instruments such as derivatives and the global operations of many public companies with their exposures to currency fluctuations have made financial reporting and financial statements much more complex than in the past, and in some ways, imprecise. Many of these items are very difficult to value or can only fairly be valued in ranges.

Auditors today, for example, must test the valuations and range of estimates in these financial statements, ascertain if they are fairly presented, and express their views in the auditor's report. Unfortunately, the truncated pass/fail model only conveys the auditor's final conclusion to users of the financial statements that the financial statements are or are not fairly presented and gives little or no clue to the many analytical processes and risk assessments that underlie those conclusions.

We know that auditors, assuming they are doing their jobs, bring expertise and experience to the audit and learn a tremendous amount about the company's financial condition during the audit. The auditors read, review, test, and corroborate the financial information presented by management. One of the auditor's most important tasks is to identify and test those areas of the financial statements where the risk of material misstatement is highest.

The auditors formulate their views of this financial information, communicate and discuss with the audit committee the results of testing and the significant risks and issues identified during the audit, and determine if the financial statements and footnote disclosures are presented fairly in all material respects. With a well informed and skilled audit committee, these discussions are often detailed and robust. Unfortunately, under the present auditor's reporting model, this information and these communications are largely masked from public view.

In considering this issue, the Board is aware of, and sensitive to, the fact that the financial statements are the responsibility of management and the board of directors, and we are fully cognizant of the risks involved in having a third party, such as an auditor, express subjective views about a company's financial condition or prospects.

The concept release presented four different alternatives for changing the auditor's reporting model: requiring and expanding the use of emphasis paragraphs, adding an auditor's discussion and analysis, adding auditor assurance on other information outside the financial statements, and clarifying the language in the standard auditor's report. The alternatives are not mutually exclusive, and a revised auditor's report could include one or a combination of these alternatives or elements of these alternatives.

The Board also held a roundtable to obtain additional views on the different alternatives and has, to date, received over 150 comment letters.

As with any proposal that contemplates substantial change, there is a wide diversity of views. There was also widespread agreement that the auditor's report could be made more relevant and useful to investors and other financial statement users. The disagreements focused on how much change is appropriate and varies to a large extent on the user (e.g., investor, preparer, audit committee member, or accounting firm).

There was almost universal support for retaining the pass/fail model for its concise and useful message and ease of comparability. Investors, however, noted that the pass/fail model should be supplemented by additional auditor reporting either in the current auditor's report or in a separate supplemental report (e.g., auditor's discussion and analysis).

Preparers and board members noted that the existing pass/fail model is sufficient for purposes of the existing financial reporting framework and that detailed discussions about the financial statements should be left to the company. These commenters noted that management is the most appropriate source for providing additional information regarding the financial statements because management has the most complete and detailed knowledge of the company's transactions and activities. They also pointed out that the U.S. securities laws assign the legal responsibility to prepare the financial statements and required SEC filings to the company not the auditor.

Preparers and board members were strongly opposed to the auditor discussion and analysis alternative in the concept release contending that it would change the long standing and, in their view, highly functional relationship between the company and its outside auditor as well as raising the possibility of "dueling disclosures" between the auditors and management. This would confuse securities markets and ultimately force management to adopt the auditor's view on any conflicting issues. They were also concerned that such a report would impede the free and candid flow of communication between management, the audit committee and the auditor. Auditors generally opposed this approach citing the levels of review and extra time it would take.

Investors took a different view. They generally believe that auditors develop a deep and expert knowledge of the financial condition of the companies they audit and have views about the risks of misstatement in the financial statements as well as the quality of the company's financial reporting. These investors believe that more disclosures about audit risks and possibly about the uncertainties inherent in estimated amounts could be very useful. Perhaps most important to investors, the auditor provides an independent third-party assessment of the company's financial condition. This does not necessarily reflect a distrust of management's disclosures, but a strong desire to have an independent and expert view as well because management's disclosures are inevitably self-serving.

Another approach that enjoyed more general support is the use of emphasis paragraphs in the audit opinion in which the auditor without offering his or her own gloss on the disclosures would emphasize areas of the financial reports and footnotes that deserve special scrutiny by the user of the reports either because they are areas of significant audit risk or because they are subject to management estimates and uncertainty. Some such disclosures would likely be mandatory and some could be optional. A concern with this approach which is, incidentally, already in use in some other jurisdictions including France, is that the disclosures could become boilerplate conveying little useful additional information. The Board is actively considering approaches that would avoid the boilerplate problem perhaps by requiring the disclosure to be tied to a discussion of specific facts in the financial statements to which they referred.

Other approaches that were widely approved by commentators are some expansion of the auditor's opinion to cover parts of the financial disclosures apart from the financial statements and footnotes such as discussions of critical accounting policies and estimates in the management discussion and analysis.

Finally, commentators generally supported some clarifications of the definitional provisions of the auditor's report such as the definition of terms such as "reasonable assurance" and the auditor's responsibility for detecting fraud.

As you can imagine, these are not easy issues to resolve. The auditor's report has not significantly changed since 1940 and it is not because standard-setters haven't tried. The Board staff is working diligently on drafting a proposed standard for the Board's consideration. One of the things the staff is considering is combining certain portions of some of the alternatives. The Board staff also is closely monitoring the IAASB's project on the auditor's reporting model, as well as the European Commission's proposed legislation.

Improving Transparency in Audit Reports

As you are aware, the typical audit report for a U.S.-listed company includes the signature of the accounting firm that issued the audit opinion and the geographical location of the firm's office. In this era of global networks firms, that signature does not tell the full story. An audit report on a multi-national company may carry the signature of one audit firm, but gives the reader no hint about the key participants in the audit such as the identity of the lead engagement partner or whether portions of the audit were conducted by one or more affiliated firms in the global network or by another auditor. The audit report also gives no information about how the audit work was allocated among firms.

In October 2011, the Board issued proposed amendments to its auditing standards to improve the transparency in the auditor's report by requiring the auditor's report to identify the audit engagement partner and to disclose the identity of any other audit firms or individuals that participated in the audit. The Board's proposal would identify the engagement partner in the audit report but not require the partner to actually sign the report.

This is not a new concept and there are several countries around the world, including in Europe, that require the audit engagement partner to sign the auditor's report. The thinking behind the Board's proposal is that in most audits there is an individual, the audit engagement partner, to whom the client looks primarily in dealing with the audit. Audit committees are often actively involved in the choice of the lead engagement partner when the mandatory partner rotation occurs. As a result, or so the thinking goes, there is no reason to mask that person's identity from investors. That being said, this proposal has been controversial. Some critics have said that the audit is a collective effort and no single individual should be singled out. While investors have stated that they were supportive of the additional disclosure, other commenters have voiced concerns about possible liability consequences of naming the audit engagement partner and whether a named partner would have to consent individually to the filing of the audit report with the SEC under SEC rules.

These amendments, if approved by the Board and the SEC, would serve two purposes. First, they would give investors more information about the identity of the lead engagement partner and the firms that are actually performing work on the audit that many investors have told us they want. In addition, identifying such firms would make publicly available the names of firms that have provided more than 3 percent of the total audit hours but are located in jurisdictions where the PCAOB cannot yet conduct inspections. Investors can then make a more informed decision about the quality of the firms participating in a company's audit.

Independence, Objectivity, and Professional Skepticism

I would be remiss if I didn't touch upon today the Board's most controversial project; an exploration of ways to improve the auditor's independence, objectivity and professional skepticism.

Last year the Board issued a concept release to solicit public comment on ways to enhance the auditor's independence, objectivity and professional skepticism. Among the approaches on which we sought comment was mandatory audit firm rotation after a period of time.

The concept release also sought comment on whether there are other measures short of firm rotation that could meaningfully enhance auditor independence, objectivity, and professional skepticism, such as mandatory tendering after a certain period, joint audits with another firm, or other solutions. As was to be expected, this proposal was highly controversial.

What, you might ask, would prompt the Board to raise a subject that could be foreseen to be so controversial, indeed, even inflammatory? Several factors influenced our thinking. There is an inherent conflict built into our system of auditor compensation where the company whose financial statements are being audited hires, fires and pays the auditor.

Second, the average tenure of the auditors of the Fortune 100 companies is about 45 years, with some much longer. IBM, for example, has had the same auditor for more than 100 years, and Coca-Cola for 91 years. Some have questioned whether tenure of that length by itself, with its implication of a large stream of audit fees continuing into the indefinite future, undermines independence.

The Sarbanes-Oxley Act imposed the requirement that audit engagement partners must rotate every five years, and opponents of mandatory rotation cite this requirement as evidence of sufficient protection against "auditor capture" by the audit client. Proponents of mandatory rotation ask whether any new audit engagement partner of a major client of his or her firm that is a long standing client of the firm can reasonably be expected to take any action that would threaten the client relationship that may be decades long. Losing such a client relationship could well be career ending for any auditor on whose watch it happened.

Perhaps most important, PCAOB inspections for the past nine years have revealed that a recurrent theme where audits fail is a lack of sufficient auditor skepticism, and the client pays model coupled with long auditor tenure may, at least in part, be responsible for that.

The Board received more than 600 comment letters with the majority of the commenters opposing mandatory firm rotation. Not surprisingly, almost all issuers and audit firms oppose mandatory rotation arguing that it would diminish the role of the audit committee and arbitrarily force auditor change even if the auditor is doing a good job. Mandatory auditor rotation is common in the U.S. among not-for-profit organizations, including some of the nation's largest pension funds and government agencies, and representatives of those organizations, as well as representatives of consumer groups, strongly favor mandatory rotation. Some commentators suggested confining auditor rotation to certain categories of issuers such as systemically important financial institutions.

Other commenters have advocated a package of reform solutions short of mandatory rotation representing a combination of measures, including, but not limited to, mandatory retendering of the audit after a period of years, further strengthening the audit committee, strengthening existing independence rules and auditing standards, improving audit firm culture and systems of quality control, and enhancing the PCAOB's inspection and enforcement programs.

In light of the varied view points and the recommended alternatives presented in the comment letters, the Board decided to hold public meetings to obtain further input on the matters discussed in the concept release. To-date the Board has held three public meetings and has heard from almost 100 speakers on this topic.

The Board also is not alone in analyzing this issue. The European Commission, through a proposal issued in November 2011, is considering requiring mandatory firm rotation every six years or every nine years for joint audits. That proposal is currently being debated in the European Parliament and Council. The lower house of the Netherlands parliament has also adopted a bill requiring mandatory firm rotation every eight years. Additionally, last month, the U.K. Financial Reporting Council changed its Corporate Governance Code to require all FTSE 350 public companies to put their external audit contract out to tender at least every ten years. If the audit committee chooses to retain their auditor after the retendering, the Code requires the audit committee to explain why in a detailed public report.

Also, there are several countries, including Italy, Brazil and India, that already require mandatory firm rotation and some countries require rotation for certain types of companies. The People's Republic of China, for example, requires rotation of the auditors every five years for its major banks. Clearly this is an issue that has attracted world-wide attention and everyone concerned with the audit business will be following it closely in the coming years.

How to enhance the auditor's independence, objectivity, and professional skepticism is a complex issue. Experience both in the U.S. and elsewhere has shown that when a company changes auditors annual audit fees typically decrease. One recent report noted that at China's three large state-owned banks that rotated this year, auditors saw an average reduction of 22 percent of the annual audit fees. Assuming previous audit fees were not unreasonable, the question arises whether such fee reductions are loss leaders to obtain business that will be adjusted in the future or whether audit quality will suffer as profit margins are squeezed. We hear constantly from preparers that they want more experienced auditors to serve on their engagements. We also know that one way to improve audit quality is to have auditors spend more time performing the audit and focusing on the critical areas and significant judgments and estimates. Our inspection findings have shown that in many cases audit deficiencies are related to insufficient time spent on particular audit areas.

As should be apparent, this is a very difficult issue and the Board will proceed with deliberation on it.

International Cooperation

At this point, I am going to switch gears and spend the remaining time on international cooperation with other audit regulators.

The PCAOB cooperates closely with audit regulators outside the United States, and the scope of that cooperation is extensive. Since 2005, we have conducted 338 inspections of PCAOB registered firms in 38 different countries.

We have cooperative agreements with 14 foreign regulators where we either conduct joint inspections or share inspection findings with regulators in those jurisdictions. We are also actively negotiating such agreements with regulators in a number of European countries and others around the world.

We have found that joint inspections are particularly useful and have conducted them with regulators in Canada, Switzerland, the United Kingdom, Germany, Norway, Spain, and the Netherlands. In these inspections, we have faced and resolved difficult data protection issues that are of great concern to regulators in the European Union and resolved confidentiality concerns that Swiss regulators have raised.

The joint inspections have demonstrated that with a cooperative approach many obstacles can be overcome. In joint inspections each regulator learns from the other and we are convinced that these inspections have improved regulatory oversight both by the PCAOB and by our foreign counterparts.

IFIAR

One of the ways the PCAOB shares experiences and its knowledge with other audit regulators is through its work in IFIAR, the International Forum of Independent Audit Regulators.

IFIAR, comprised of independent audit regulators, was formed in September 2006 to provide a forum for regulators to share knowledge of the audit market environment and the practical experience gained from their independent audit regulatory activity. Only regulators that are truly independent of the auditing profession are eligible for membership which has grown steadily to 44 members today with over 10 candidate members in various stages of the application process.

The United States has come to play a leadership role in IFIAR and I was honored recently to be elected Vice-Chair of the organization. IFIAR holds annual plenary meetings at which regulators from around the world meet to exchange information on a variety of topics including general inspection findings, standard-setting initiatives and cross-border cooperation. We just concluded our twelfth meeting in London earlier this month. In addition, there are five working groups that meet more frequently and focus on specific issues like standard setting, international cooperation, investor concerns, inspections training and public policy.

One of the most important is the last, the Global Public Policy Committee Working Group, that meets three times each year with the leadership of the six global network audit firms to discuss issues of concern to the regulators and the firms. IFIAR also conducts an annual inspection training workshop for audit inspectors from around the world.

For the first time this year, IFIAR has surveyed its members about their audit inspection findings. Almost all IFIAR members responded to the survey and while the results are presently confidential, I can tell you that a striking result of the survey is that other regulators around the world seem to be finding the same types of defects in their inspections that the PCAOB is finding, particularly deficiencies in auditing fair value measurements, testing internal controls, revenue recognition and engagement quality control reviews. IFIAR is currently working on a summary of the report to be published by the end of the year.

You might ask why an organization like IFIAR is important. The short answer is that it enables individual regulators to get a better window on the global landscape of audit practice and financial reporting. This is important because the world's largest enterprises — those that represent the largest share of global economic activity and shareholder wealth -- operate globally.

Not only do they sell products globally, but increasingly they purchase raw and component materials, manufacture, distribute, and do research and development globally. One only needs to look at some of the latest signature industrial products, like new automobiles, computer and smartphone products, or the Boeing 787 airliner to realize that these products are produced from designs and components sourced and manufactured in many different countries.

A global company, perhaps operating in more than 100 countries, also has financial reporting activities in many, if not all, of those countries. Any regulator, confined to a view within its own borders, can only see a portion, and often a small portion, of the activities and risks of such an enterprise. Cross-border regulatory cooperation, working together and sharing information, is vital to our common mission to improve the protection of investors who rely on auditors to assure that the financial reports of publicly traded companies are transparent, complete and fairly stated.

Just as the largest corporations in the world have become increasingly global in their operations, their auditors must be able to conduct audits on a global basis. The largest audit firms have grown globally along with their clients.

But unlike their corporate clients, which usually operate globally through a centrally controlled structure of parent and subsidiary entities, the global audit firms operate as an affiliation of individual audit firms. They are organized and operating under the laws of different political and regulatory jurisdictions joined together in networks where they share clients, training, audit methodologies, and quality assurance practices.

In the audit of a major global corporation, a number of different auditing firms, operating under a single trade name, will cooperate to perform the audit of the corporation's global operations. Today, the auditor's report on such a corporation is signed by only one firm in the network and does not reveal whether other affiliated firms participated in the audit or the extent of their participation.

The reality of today's global business environment means that regulators around the world must do the same thing. We must cooperate effectively with each other if we are to ensure that audit quality remains high and that investors are protected.

China

Now, let me turn to China. As you are probably aware, in the past year or so, alleged serious financial frauds and attendant accounting problems have been disclosed involving a number of China-based companies whose securities are registered outside of China, particularly in the United States, Singapore and, to a lesser extent, Europe.

Not more than a decade ago, Chinese firms began to access foreign capital markets. Two types of Chinese companies sought access to U.S. capital markets, smaller enterprises that had difficulty accessing the very restricted Chinese domestic capital markets and some of the largest state-owned enterprises in industries such as petroleum and telecommunications. At the same time some of the largest global companies, including U.S companies, began to engage in extensive operations in China.

The smaller companies most commonly sought access to U.S. markets by merging with existing, registered U.S. shell companies in reverse mergers. The larger companies filed initial public offerings.

Beginning in the latter part of 2010, alleged financial frauds and serious accounting issues were revealed at a number of the smaller Chinese reverse merger companies. To date, 67 of these China-based issuers have had their auditor resign, and 126 issuers have either been delisted from U.S. securities exchanges or "gone dark" — meaning that they are no longer filing current reports with the SEC. Billions of dollars of market capitalization of such companies have been lost in U.S. securities markets and it is fair to say that all of these smaller China-based companies listed on U.S. securities exchanges have suffered serious losses of both market value and investor confidence as a result of the problems of other companies.

The number of China-based companies that have successfully filed an initial public offering in the United States in the past year has slowed to a trickle. We understand that smaller Chinese companies have also suffered similar adverse consequences in other non-U.S. and non-Chinese markets.

At present, the PCAOB does not have cooperative agreements with either the China Securities Regulatory Commission or China's Ministry of Finance which share jurisdiction over Chinese accountants. The CSRC has jurisdiction over the 53 accounting firms, including the affiliates of the global network firms that are authorized to file audit reports with respect to companies listing securities on the Chinese domestic securities markets in Shanghai and Shenzhen. The MOF licenses all accountants in China and has jurisdiction over more than 7,000 accounting firms in China, including some of the firms registered with the PCAOB.

Under Chinese law, it is illegal to remove audit work papers from China. At the present time, Chinese authorities will also not permit any non-Chinese regulator to conduct inspections on Chinese soil. As a result, it is impossible for the PCAOB or other regulators to inspect China-based audit firms or to assess the quality of such firms registered with it. This limitation also applies to the affiliates of the global network firms that perform audit work on the audits of the Chinese operations of the large global companies operating in China.

In an attempt to address these problems, the PCAOB has intensified its dialogue with both the China Securities Regulatory Commission and the MOF over the past year. Both we and the Chinese regulators recognize the importance of improving audit quality and investor protection.

For the PCAOB, an agreement with China is important not only because of the risks investors face, but because of the size and rapid growth of the Chinese economy. Almost 5 percent of PCAOB registered firms are based either in China or Hong Kong, the largest group of non-U.S. firms.

Chinese authorities say that we should rely on their oversight of auditors. They have two principal concerns. The first is that any action by a foreign regulator on Chinese soil, even a mere inspection, could violate Chinese sovereignty. This concern has deep historical roots, specifically relating to the humiliations that China suffered at the hands of Western powers in the nineteenth and early twentieth centuries.

The second concern grows out of China's very expansive state secrecy laws. There has been a concern expressed that inspection of audit work papers, particularly work papers from the audits of state-owned enterprises, could lead to disclosures of state secrets.

The question for both countries is how to conduct inspections in ways that respect national sovereignty and the legitimate regulatory goals of both countries. As mentioned earlier, we have been able successfully to navigate or balance these seemingly competing interests in a number of countries around the globe.

As a first step toward further cooperation, we have agreed on observational visits where PCAOB inspectors will observe the Chinese authorities conducting their own audit oversight activities and the Chinese could observe the PCAOB at work. The observational visits as outlined by the guidelines will be completed shortly. This is not be a substitute for a PCAOB inspection but is a trust building exercise between regulators. We hope such exercises will build trust and lead to further cooperation. The ultimate goal for the PCAOB is to achieve a level of cooperation with the Chinese authorities that will enable us to have enough information and confidence that we could issue inspection reports on those China-based audit firms that prepare or participate substantially in the preparation of audit reports filed in the United States. We believe that we share a common goal with China to enhance investor protection and hope that we will be able to achieve meaningful cooperation.

Conclusion

With the economic climate around the world remaining uncertain, this is just the time that investors most need protection. It is the duty of all of us involved in the financial reporting process, whether as preparer, manager, audit committee member, auditor, counselor or regulator to work to ensure that financial reports are complete, transparent, and fairly stated. We value the strong relationship we have developed with the state boards of accountancy in advancing this mission and look forward to continued close cooperation with you.

Thank you for your attention.